100400 US FX MOD1 3ED · The spread is a function of market conditions and liquidity, and allows a Market Maker to make money from accepting Forex trades. The spread aside, our Forex

The basics

Module 1The basics

In this module we look at the basics of Forex and the mechanics of howtrades work, with a number of worked examples. We also look at themajor currency pairs and discuss the advantages that Forex trading off ers.

TradeSense UK, April 2010, Edition 6

2 Module 1: The basics

Forex

The Foreign Exchange market (Forex) is the largest and most liquid financial market in the world.

It is a truly global market with no physical central location; instead the market consists of an international OTC (Over The Counter) network of ‘major dealers’ (mainly banks) that function throughout financial centers around the globe. This system of banks and brokers dealing directly with one another is called the Interbank Market. Trading moves with the sun around the earth, beginning at the start of the business day in the Asia-Pacific financial centers and moving across the Middle East, to Europe and then America, before seamlessly moving back to the Asia-Pacific region. This allows Forex trades to be placed at anytime, day or night: the market is open 24-hours a day during the business week.

Historically, the Forex Interbank Market was the private realm of banks, corporations and the extremely wealthy, mainly because of the large minimum transactions that were required. But with the rise of the internet, the Forex markets are readily available to just about everyone.

IG Markets offers tight bid/offer spreads and excellent execution on an extensive list of currency pairs. Although by using our service you are not dealing in the Interbank Market, the quality of service in terms of spread and speed of execution is comparable to that available to the major players.

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3Module 1: The basics

The exchange rate is a price: how much of one currency must be relinquished in order to obtain one unit of another currency and, like all market prices, Forex rates are determined by the actions of participants in the market. Put simply, Forex rates are a result of supply and demand.

We offer Spot Forex trading, the type of trading around which the Foreign Exchange markets revolve. A Spot Forex trade is a straightforward exchange of one currency for another, and therefore comprises two concurrent trades: buying one currency and selling another. Consequently, rates are always quoted (and traded) as pairs.

The name of Spot implies a cash transaction, but in the Interbank Market a Spot transaction is not immediately settled. The convention is for the settlement date to be set as the second business day after the date on which the trade is made. This two-day period is to arrange for clearing (the debiting and crediting of the bank accounts involved, which may be across differing time zones).*

In the retail market, no trades are actually settled by way of an actual physical exchange of currencies: when you trade with IG Markets all transactions are cash settled (the Interbank convention of two-day settlements does have some bearing on how some of our procedures operate, as we shall see).

Let’s look at a simple example to see how a trade might work.

*As an aside, Spot trades between the Canadian dollar and the US dollar are the exception to the rule and are conventionally settled one business day after a trade is struck; the earlier settlement date is practicable because of the shared time zones between Canada and the United States. This has no bearing when trading Forex with us, however.

The basics: how does it work?

Foreign Exchange means the exchange of one currency for another.


Example: buying USD/JPY

With one US dollar worth roughly 93 Japanese yen, you decide that the dollar is likely to increase in value against the yen. Consequently you check what rates we are quoting.

Any Forex rate represents a ratio: the amount that one currency is worth expressed in terms of a second currency. The first named currency, US dollars in this case, is known as the base currency and is always set as one, so that the rate is an expression of the second named currency (known as the counter or quote currency) per unit of the base currency. The exchange rate between US dollars and Japanese yen is written as USD/JPY (which is called ‘Dollar-Yen’) and therefore expresses the number of yen that one dollar is worth.

The fact that the rate is a ratio of yen per dollar (or to express another way the ratio is

yendollar ) may seem confusing when the convention is to

label the rate as USD/JPY.

It is best just to remember that the rate is always an expression of the second named currency per unit of the base currency so that USD/JPY = 93 means 1 USD = 93 JPY.

Apart from convention, there is no express reason to quote the rate this way round (i.e. number of yen per dollar); it is, of course, possible to quote JPY/USD . However, this is generally not done in the Spot market and we always quote the price as USD/JPY.

5Module 1: The basics 5Module 1: The Basics


What does this mean? The bid/offer (the lower number of 93.56 is the bid and the higher number of 93.59 is the offer) represents the two prices at which you can currently deal. If you thought that dollars are going to weaken against yen (i.e. the number is going to fall, as one dollar becomes worth fewer yen), you would deal at the bid, and you would be selling dollars and buying yen. The convention is to describe this as ‘selling dollar-yen’. If you thought that dollars are going to strengthen against yen (i.e. the number is going to rise, as one dollar becomes worth more yen), you would deal at the offer, and you would be buying dollars and selling yen. The convention is to describe this as ‘buying dollar-yen’. When someone says they are buying or selling a rate, it always refers to the first-named currency (it is implied that they are always dealing in the opposite direction on the second-named currency, so that someone ‘selling dollar-swiss’, for example, is selling dollars and buying Swiss francs).

The difference between the bid and offer is known as the spread. The spread is a function of market conditions and liquidity, and allows a Market Maker to make money from accepting Forex trades. The spread aside, our Forex service is commission-free.

In the case of this example, you think that dollars are going to strengthen against yen, and so you are ‘buying dollar-yen’ and dealing at the offer price of 93.59. This number means that one dollar is worth 93.59 yen. Traditionally market convention has been to quote USD/JPY to two decimal places (other Forex rates are quoted to a greater number of decimal places, as we shall see later). A movement in the price from 93.59 to 93.60 is described as being a one ‘pip’ movement, with one pip being the smallest movement that traditionally would occur in the price.

The bid/offer quote

When you check with us, you find that in this case we are quoting USD/JPY as 93.56/93.59.


Precision QuotingNowadays, however, there is growing pressure for prices to be quoted to a higher degree of precision (as spreads have tightened) and a growing number of banks in the Interbank Market are making prices that include a further decimal place.

Logically, if a pip was to be kept as the smallest price movement that could occur, it would mean considering one pip as being the next decimal unit. As participants in the market are familiar with the traditional value of one pip, however, (one hundredth of a yen in the case of our example), the practice is to quote the rate in the conventional manner, keeping the value of one pip the same, but making the quote to an extra decimal place (so that the pip is the second-to-last decimal place).

Hence, 93.59 becomes 93.590.

We conform to this more precise method, and effectively quote our rates to include fractions of a pip (for simplicity’s sake this example will use only whole pips, but later examples will show quotes with the additional decimal place included).

A further piece of market jargon is that 100 pips is referred to as a ‘big figure’: if USD/JPY was to move from 93.59 to 91.59 we would say that the level had dropped by two big figures.


Transaction sizes

As well as deciding that you are buying dollars and selling yen, you also need to decide how big your position is going to be: in other words, what amount of currency you are going to trade, which will define your exposure to the exchange rate.

We offer trading in ‘contracts’ (also known as ‘lots’). This is a defined trading unit, controlling 100,000 units of the base currency. We also offer mini contracts that offer exposure of 10,000 units of the base currency.

So, one contract of USD/JPY controls $100,000. One mini contract controls $10,000.

We have already stated that the USD/JPY rate represents yen per unit dollar and that one pip represents 0.01 of this rate. In other words, one pip in this case represents 0.01 yen per dollar. Multiplying through one pip by the value of one contract will give us the exposure per pip that one contract offers.

So for one standard contract, one pip = 0.01 x $100,000 = ¥1000

And for one mini contract, one pip = 0.01 x $10,000 = ¥100

You decide to buy two mini contracts of USD/JPY. The quoted rate was 93.56/93.59 and you are happy to deal at that price. You therefore place an order to buy.

A market order is an instruction to buy or sell at the current market price.

You therefore buy two mini contracts of USD/JPY at 93.59. This means that you will make ¥200 for every pip that the rate increases above 93.59 and lose ¥200 for every pip that the rate falls below 93.59 (two mini contracts, with an exposure of ¥100 per pip per mini contract).

¥ $

¥ $


You are buying two mini contracts. Each mini contract is worth $10,000 so the total value of your position is $20,000. USD/JPY is margined at just 2%. You therefore only need to deposit $400 with us (strictly speaking, the deposit required would be the yen equivalent, using the rate at which you dealt).

The fact that you can use a certain amount of money to command an amount that is many times greater is one of the key advantages that Forex trading offers.

This effect is called ‘leverage’ (also called ‘gearing’, this concept is discussed in detail in Module 4).

In the case of our example, you are leveraged 50 to 1, as the position you have taken (2 mini contracts worth $10,000 each) is 50 times larger than the money you have deposited ($400).

Margin

When you trade Forex you do not need to deposit the full amount of currency that you are commanding. Instead, you are required to deposit an initial amount of money that is only a fraction of the value of your position. This amount is known as the ‘margin’. The margined required when trading Forex starts at just 2% for our more popular currency pairs.


If a speculator holds a position beyond the close of the current business day, the open position is netted off and then re-established for the next day at a new rate (known as a rollover).

This new rate is calculated as the closing level of the old position plus or minus an adjustment which is determined by the difference in interest rates between the two pertinent currencies (the overall process of closing and re-opening with an adjustment is known as a ‘Tomorrow Next Day’ – or ‘Tom Next’ – procedure).

Virtually all retail Forex platforms now perform rollover automatically, so as to allow Forex speculation to continue beyond day-trading time frames only. The better the platform, the more seamless the rollover. With us, the process is taken one stage further, so as to be completely seamless: there is no expiry or rollover. Instead your position remains open until you choose to close it, and whilst your position is open, adjustments are made on a daily basis to replicate the effect of Tom Next calculations.

In Forex you are, in essence, lending one currency while simultaneously borrowing another. In the case of our example, where you are buying dollars and selling yen, you are effectively borrowing yen in order to hold dollars. You therefore receive interest for holding dollars and pay interest on the borrowed yen. The interest rate adjustments that we make are based on actual Tom Next rates taken from the Interbank Market.

Interest rate adjustments

Although the name ‘spot’ suggests same-day settlement, in the underlying Forex market, transactions which are entered into today (the trade date) – and held to settlement – are settled (for the most part) two business days after the trade date. In practice, the vast majority of individuals trading FX are speculating, with no plans to take delivery of physical currency.


The actual daily interest adjustment that we make also includes an administrative charge. This rate is variable, but will not exceed 0.3% for a standard contract.

Interest rate adjustments are only made on positions that are still held at 5pm EST (this is because 5pm EST coincides with the market opening in Singapore, which is considered the start of the international trading day).*

You have bought dollars and sold yen. Our adjustment is therefore replicating a Tom Next swap of selling dollars/buying yen (closing the existing position) and simultaneously buying dollars/selling yen (re-opening).

Let’s say that the bid/offer of our Tom Next rate, including our administrative charge, is -0.0013/-0.0007 ¥/$.

As you are buying USD/JPY on the re-opening, you would be buying at a rate that differs from the closing rate by the offer of the Tom Next rate. In other words, you would be re-opening at a rate that is 0.0007 points lower.

We reflect the benefit of buying at this discount by crediting money to your account.

This amount is:

2 contracts x $10,000 x 0.0007 ¥/$ = ¥14

¥14 is credited to your account balance: the US interest rate is higher than the Japanese rate, so that the interest you accrue for being long (holding) dollars is greater than the interest you pay for being short (borrowing) yen (and is sufficiently large to yield an interest credit after the IG charge is incorporated).

Had you been short dollars and long yen you would have been charged an amount that would be calculated using the bid of the Tom Next rate.

Every day that you hold a position up to 5pm EST, such an adjustment occurs.* For weekends, the interest adjustment is for three days worth of interest. This adjustment is made on Wednesdays: this derives from the conventional market concept of a trade having a two-day settlement (a trade opened on Wednesday with a settlement date of Friday would be rolled into a settlement date of Monday: a ‘flip’ of three days).

*The times quoted ignores the effects of daylight saving. Please note times will differ if daylight saving is in effect.


Closing your position

Over the next few days, your forecast that the dollar would strengthen proves correct, as the USD/JPY rate steadily increases. Six trading days after you opened the position, USD/JPY is trading at 94.74/94.77. You decide to take your profi t.

You sell two mini contracts at 94.74, the bid of our quote, to close your position.

Your profi t on the trade, before taking into account interest adjustments, is calculated as follows:

Closing transaction = ¥10,000 x 2 contracts x 94.74 = ¥1,894,800

Opening transaction = ¥10,000 x 2 contracts x 93.59 = ¥1,871,800

Profi t on trade = ¥1,894,800 - ¥1,871,800 = ¥23,000

Another, perhaps easier, way to calculate the profi t is to consider how many pips you made and then multiply it by the value per pip of your two mini contracts.

We said earlier that one mini contract meant ¥100 per pip, so two mini contracts would mean ¥200 per pip.

The total number of pips you made can be found from subtracting the opening level from the closing level:

Closing level 94.74

Opening level 93.59

Diff erence 1.15

1.15 big fi gures = 115 pips.Profi t (excluding interest adjustments) = 115 pips x ¥200/pip = ¥23,000

To arrive at the overall profi t on the trade, we also have to consider the adjustments made for interest.

You held the position for six trading days. This might amount to a total credit of ¥89.

Your overall profi t is therefore ¥23,000 + ¥89 = ¥23,089


The major currency pairs

USD/JPY is one the ‘majors’: the six most liquid and widely traded currency pairs in the world (trading in these pairs accounts for more than 90% of all Forex trades).

The table below shows the majors with some useful information about the contracts we off er:

Symbol Currency Alternative/ Example Example bid/ One pip Value of one pip Value of one pair nickname rate off er quote (per Standard pip (per Mini contract) contract)

AUD/USD Australian Aussie-dollar 0.9321 0.9320/0.9322 0.0001 USD10 USD1 dollar vs US dollar

EUR/USD Euro vs US dollar Euro 1.35395 1.3539/1.3540 0.0001 USD10 USD1

GBP/USD British pound Cable 1.5401 1.5400/1.5402 0.0001 USD10 USD1 vs US dollar

USD/CAD US dollar vs Dollar-Loonie 0.9992 0.9990/0.9994 0.0001 CAD10 CAD1 Canadian dollar

USD/CHF US dollar vs Dollar-Swissie 1.0597 1.0595/1.0599 0.0001 CHF10 CHF1 Swiss franc

USD/JPY US dollar vs Dollar-yen 93.11 93.10/93.12 0.01 JPY10 JPY1 Japanese yen

Our Forex service covers a very wide range of currency pairs, including crosses against all the Scandinavian currencies and a large number of ‘exotic’ crosses (exotic refers to less common currency pairs, and includes rates against such currencies as the Hungarian Forint, the Mexican Peso and the Polish Zloty, to name but a few). Full details of the currency pairs we off er can be found on our website www.igmarkets.com/fx.

USDAUD

USDEURUSDGBR

CADUSD

CHFUSD

JPYUSD


This has led to an explosion in popularity of Forex trading in the retail market, which has a number of excellent benefits:

No CommissionsMaking a return from trading is tough enough without having to pay a commission on every trade, which could make the difference between a good return and a very ordinary return. We do not charge commission: all our costs are tied up in the bid/offer spread, which start from just one pip on some of the majors.

You should, of course, still take into account the spread and how it affects any trading strategy that you employ.

LeverageOur small margin requirements allow you to maximize your trading power: on some of our most popular forex pairs you can trade by putting down just 2% of the underlying value, offering leverage of 50:1.

For example, taking a position equivalent to $100,000 on EUR/USD would require a deposit of only $2000.

Advantages of our Forex service

As mentioned earlier, advances in technology (particularly the internet) now allow retail customers trading opportunities previously available only to major players in the market.


Speed of executionWhether you are dealing over the telephone or via the internet, transactions are executed very quickly, with internet deals typically transacted in just fractions of a second.

LiquidityMuch is made of the fact that the Forex market is the most liquid market in the world and this brings benefits in the form of competitive margins, availability of tight spreads, decreased chances of rates ‘gapping’and the ability to trade in large size relatively easily.

24-hour tradingWe offer a true 24-hour Forex trading service and every currency pair we offer can be traded at any time of the day or night during the international business week.


SummaryBy now you should:

Be more familiar with Forex conventions for quoting currency pairs

Understand what our Forex quotes mean

Be able to work out the value of a ‘pip’ for our standard and mini contracts

Understand how and why we make daily adjustments for interest

Be able to calculate the profit and loss for a given currency trade

Know about the major currency pairs

Be aware of the benefits of Forex trading

Please remember that our Forex Trades are a leveraged product and can result in losses that exceed your initial deposit. Trading Forex with us may not be suitable for everyone, so please ensure that you fully understand the risks involved. You should of course note that, without proper risk management, a high degree of leverage can lead to large losses as well as gains.

IG Markets

311 South Wacker Drive

Suite 2650

Chicago IL 60606

US Toll Free: 866 748 1340www.igmarkets.com/fx

Documents

100400 US FX MOD1 3ED · The spread is a function of market conditions and liquidity, and allows a Market Maker to make money from accepting Forex trades. The spread aside, our Forex